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Ron Copley founded Copley Investment Management (CIM) in 1985. Prior to that, Ron served in the 5th Special Forces Group in the US Army from 1966 to 1969 during which he received the Bronze Star Medal for valor as an infantry officer in Vietnam. After his military service, Ron pursued his... More
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  • Retirement Planning Using A Goal-Based Investment Strategy 0 comments
    Jan 25, 2013 3:43 PM

    Case Study: Goal-based Investment Strategy

    A prior article presented an intuitive concept for financial planning before and during retirement-that of goal-based investing. This month's column presents a case study of how a couple, Bob (66) and Sue (60), can use goal-based investing when planning their future.

    What is goal-based investing?

    Goal-based investing employs the simple idea of investing in a bond with a maturity matching the timing of your goal. If, for example, your goal is to have $10,000 five years from now, you would invest in a riskless US Treasury Inflation Protected Security (NYSEARCA:TIP) bond maturing in 5 years. Because the bond is risk-less and because the principal of the TIP grows with inflation during the 5-year interim, you are assured that the money will be there when you need it and that you are protected against inflation.

    An important aspect of goal-based investing is that it views risk as the consequence of not meeting a future goal. This view is quite different from the traditional view of risk as the volatility of returns. Pension funds have been using this asset/liability matching principle for years, although it is relatively new to individual investors.

    Bob and Sue's Monthly Income and Expenses

    Bob (66) is drawing Social Security (SS) benefits of $2,500 per month. Sue (60) is still working and earns $3,000 per month before taxes; she intends to retire in 3 years. When Sue retires at age 63, she is planning on drawing reduced SS benefits based on Bob's benefits until she reaches full retirement age of 66 at which time she will switch to her own benefits based on her work history. She estimates that her reduced benefits will equal $1,000 per month at age 63 and increase to $1,800 per month at age 66. Bob and Sue have a 25-year planning horizon.

    Table 1. Bob and Sue's Monthly Income and Expenses

     

    Sue (age 60)--today

    Sue (age 63)

    Sue (age 66)

    Bob: SS benefits1

    $ 2,500

    $ 2,814

    $ 3,075

     

    Sue: Wages1

    $ 3,000

    $ -

    $ -

     

    Sue: SS benefits1

    $ -

    $ 1,000

    $ 1,800

     

    Pre-tax Combined Income

    $ 5,500

    $ 3,814

    $ 4,875

     

    Less: Taxes (Fed and State)2

    $ 1,650

    $ ($953)

    $ (1,219)

     

    After-tax Combined Income

    $ 3,850

    $ 2,860

    $ 3,656

     

    Less: Living Expenses3

    $ (3,000)

    $ (3,877)

    $ (5,828)

     

    Surplus (deficit) Income4

    $ 850

    $ (1,452)

    $ (3,103)

     

    1 Increase at the assumed rate of inflation of 3%.

    2 Fed and State taxes at 30% while Sue works, but drops to 25% when she retires at age 63.

    3 Living Expenses increase by $500 per month to cover Sue's health insurance when she retires at 63.

    4 Includes extra taxes paid on withdrawals to cover deficits.

    Table 1 shows that the couple's combined pre-tax income currently equals $5,500 per month. After paying taxes ($1,650) and living expenses ($3,000), their combined take-home surplus income of $850 per month is available for saving for 3 years until Sue retires at age 63.

    At age 63, Sue will lose her wages but gain SS benefits giving the couple a combined pre-tax income of $3,814 per month. After paying taxes ($953) and living expenses ($3,877) each month, they will be short $1,452 per month until Sue reaches age 66.

    At age 66, Sue's monthly SS benefits will increase to $1,800. After paying taxes ($1,219) and living expenses ($5,828), they will have to withdraw $3,103 per month for the remaining years in their 25-year planning horizon. Bob and Sue have no mortgage or any other outstanding debt. They pay off their relatively small credit card balances at the end of each month. Their two grown children live out-of-state and are financially independent.


    Health Insurance

    Bob has purchased a supplement policy (Medicare Part B) the cost of which he has included in their monthly living expenses. Until she retires, Sue is covered by her employer's health insurance plan. When she retires, Sue will have to purchase health insurance for 2 years at an estimated cost of $500 per month until she reaches age 65 when she will be covered by Medicare. Like Bob, Sue will purchase a supplemental policy (Medicare Part B) at age 65 at an estimated cost of $500 per month.

    Bob and Sue's Parents

    Bob's parents are both deceased. Sue's father is deceased, and her out-of-state mother is in failing health. Sue periodically visits her mother and helps some with medical bills, which she has included in their average living expenses. Sue does not expect to receive any inheritance when her mother dies; Bob received none when his parents died.

    Investments

    Table 2 shows that Bob and Sue have total savings of $640,000 consisting of both retirement and non-retirement accounts. Of the $640,000 total, $425,000 (66%) is invested in the stock market and the remainder is in CDs or cash.

    Table 2. Bob and Sue's Savings Today

       

    Bob: 401k

    $300,000

    Stock Mutual Funds

     

    Bob: Bank

    $150,000

    Bank CD (near cash)

     

    Sue: IRA

    $50,000

    Bank CD (near cash)

       

    Sue: Retirement Annuity

    $125,000

    Stock Mutual Funds

     

    Joint Checking Account

    $15,000

    Cash

     

    Total Savings

    $640,000

     

    Current and projected financial picture

    At this time, Bob and Sue are in good financial shape for a couple of reasons. First, as we saw in Table 1, they are living within their means. Their combined monthly incomes show that they can save for the next 3 years after which they will have to dip into their savings during their retirement years. The question now is, how should they invest their saving in order to safely generate withdrawals of $1,452 per month for 3 years followed by withdrawals of $3,103 per month for the rest of their lives? They have two major concerns: inflation and health care. For purposes of planning, the couple assumes that their incomes from SS, their living expenses, and taxes will all increase by the rate of inflation. While this assumption may not be accurate, Bob and Sue will build into their investment plan a margin of error that will allow for inaccuracies in their estimates.

    A goal-based investment strategy for Bob and Sue

    Bob and Sue have decided on a 3-phase investment strategy as shown in Table 3.

    Table 3. Bob and Sue's 3-Phase Investment Strategy1

     

    Phase I (Sue, 60-63)

     

    Phase II (Sue, 63-66)

     

    Phase III (Sue, 66-91)

    Saving (withdraw)

    $850/mo

     

    Withdraw $1,452/mo

     

    Withdraw $3,103/mo

    Begin Value

    $640,850

     

    $722,743

     

    $780,909

    Ending Value

    $722,743

     

    $780,909

     

    $1,069,286

    1 All calculations in Excel Spreadsheet (not shown) assume savings increase at the annual rate of 3%.

    Phase I. Bob and Sue can save $850 per month while Sue continues her employment over the next 3 years. Their beginning saving should, thus, increase from $640,000 to $722,743 at the end of year 3.

    Phase II. When Sue retires at age 63, the couple will begin withdrawing $1,452 per month from their saving over the subsequent 3 years. Based on an ending savings value of $780,909, the $1,452 equals an annual withdraw rate of 1.7 percent. Since the withdraw rate is less than the assumed rate of return of 3 percent, the savings will continue to increase.

    Phase III. At age 66 when Sue begins drawing SS benefits on her own work history, they will have to withdraw $3,103 per month over their planning horizon of 25 years. Again, the withdrawal rate is less than the assumed rate of return, which means that their savings will continue to increase to $1,069,286 at the end of year 25.

    Conclusions

    The above analysis suggests that Bob and Sue are currently following an overly aggressive investment strategy that exposes them to much more risk than they should be taking. With 66 percent of their savings invested in the stock market, they could lose up to 50 percent of their equity savings if the stock market were to fall in the future the way it did in 2008. If that were to happen, Bob and Sue could find themselves facing some serious trouble.

    A goal-based investment strategy views risk as the consequence of not meeting a future goal. Bob and Sue would be foolish to pursue an investment strategy oriented toward the stock market when investing in risk-less TIPs would allow them to meet their goals and still have sufficient funds to meet unexpected expenses.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Themes: retirement
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